INVENTORY VALUATION METHODS

Remember that this is based on the standard periodic

inventory model:

Net Sales
Beginning inventory
+ Net Purchases & Freight
= Goods Available for Sale
- Ending inventory
= ..................................> - Cost of goods sold
=Gross Margin

THE MAJOR OBJECTIVE: Determine the cost that will be

associated with ending inventory. Notice that this will directly
affect COGS and thus Gross Margin.

FOUR COMMON VALUATION METHODS:

1. Specific identification
2. Weighted average
3. First-in, first-out (FIFO)
4. Last-in, first-out (LIFO)

Information for examples:

#Items Unit Cost Total Cost

Beginning inventory
200 $2,400
Purchase #1 $12.00
400 5,200
Purchase #2 13.00
300 4,110
Purchase #3 13.70
350 4,970
Goods Available for 14.20
1,250 $16,680
sale

Units Sold 870 At $20 $17,400

Units Remaining 380

A. Specific identification. Actually value ending inventory

at what each individual item cost. Used to be used only
for large items. With bar-coding, now used more
frequently. No numerical example needed as you must be
given the information.
B. Weighted average. Determine one average cost by
dividing total costs by total units. Use units remaining to
determine ending inventory.

16,680/1,250 = $13.344 x 380 = $5,071 ending inventory

Goods Available for Net sales

16,680 $17,400
Sale -Cost of Goods
5,071 11,609
-Ending inventory Sold
11,609 $5,791
=Cost of goods sold Gross Margin

C. First-in, first-out (FIFO). If you assume that those

purchased first were sold first, then those remaining
would be the last ones. This makes sense from a physical
flow standpoint, but it DOESN’T MATTER. You can use any
of these methods for the "costs" regardless of whether
you sold the first ones first or the last ones first or a
combination! However, the FIFO method values the
ending inventory as if you sold the first ones first.

Remaining 350 x 14.20 4,970

units: 30 x 13.70 411
ending
380............. 5,38l
inventory

Goods Available for Net sales

16,680 $17,400
Sale -Cost of Goods
5,381 11,299
-Ending inventory Sold
11,299 $6,101
=Cost of goods sold Gross Margin

D. Last-in, first out (LIFO). If you assume that those

purchased last were sold first, then those remaining
would be the first ones. Although this doesn’t usually
make sense from a physical flow standpoint, again IT
DOESN’T MATTER. The actual flow does not need to
match the one chosen for the costs.

Remaining 200 x 12.00 2,400

units: 180 x 13.00 2,340
ending
380............. 4,740
inventory

Goods Available for 16,680 Net sales $17,400

Sale -Cost of Goods
4,740 11,940
-Ending inventory Sold
11,940 $5,460
=Cost of goods sold Gross Margin

SUMMARY OF THREE METHODS

FIFO W.Avg. LIFO

Gross Margin $6,101 $5,791 $5,460

Ending Inventory $5,381 $5,071 $4,740

Things to notice:

1. When prices are rising, LIFO gives the

lowest profit and FIFO the highest.

2. The LIFO profit is the closest to measuring

the cost of goods sold as the cost to replace
the inventory.

3. When prices are rising, FIFO gives the best

measure of the cost of the ending inventory at
current prices

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Advantages and Disadvantages

of All Four Methods

Method Advantages Disadvantages

Specific Identification Exactly matches costs Easy to manipulate

Hard to apply to many

small items

Weighted average Hard to manipulate Averages may not reflec

inflation well
 Easy to calculate

FIFO Hard to manipulate Produces "inventory"

profits
Makes physical sense
Doesn’t minimize taxes
Good ending inventory
valuation

LIFO Minimizes taxes in Easy to manipulate

inflation
Physical flow unrealistic
Reflects current costs
Bad ending inventory
valuation

Can’t use for foreign

LIFO liquidation probs.